Trading the Flag patterns the right way

04/26/201406/10/2014 by Editorial Team

In the realm of the many different types of chart patterns, the flag patterns presumably fall into the category of one of the most safest chart patterns to trade. The reasoning behind this statement comes from the very definition of flags (and pennants).

Definition of the Flag Pattern

A flag (Bullish or Bearish) is indicative of a continuation of the prevailing (underlying or the main) trend. When a flag pattern is identified on the chart, it usually points to a pause in a rally creating a tight range type of price action. This pause usually results in a break out as price tends to resume its previous trend.

Unlike other chart patterns such as the famous Head & Shoulders, which generally points to a reversal of trend (or in some cases as a continuation pattern), it is relatively difficult to trade the H&S pattern compared to the flag pattern.

Therefore, trading flags gives the trader the all important trend direction and thus reduces the risks of the trade reversing. Despite the simplicity of flags, they are very deceptive when trading in real time. While there are many resources available on the Internet that talk about flags, in this article we look at flags under a microscope as well as outline a few rules that offers a good high probability trade usually with a good risk to reward ratio.

While pennants too are continuation patterns, in this article we focus just on flags as they are easy to identify.

Identifying a Flag Pattern on the chart

Flags, are formed both during an uptrend and during a downtrend. The following rules must be met in order for a chart pattern to qualify as a flag.

Price usually makes a sharp move. This can be identified with wide bodied candlesticks (or wide bars) or even lines on a line chart. In this move, there are usually no retracement or if there are, the retracements are very small in comparison

After a sharp move, price starts to consolidate within a range. During this phase, markets are usually slow and price also tends to slowly align to the opposite direction of the previous move

After price consolidates for a certain period of time, we can identify the pattern as a flag when the previous move was a sharp rally followed by the consolidation phase where price trades within a range and usually forms a slope.

Note: If the slope is too steep, it does not qualify as a strong flag pattern

Qualifying a flag pattern in the chart

Most literature on the Internet usually plot flags as price making a zig-zag pattern making alternative contact points. This does not have to be the case. Price can make as many contacts within the flag and they do not have to be in a zig-zag fashion.

The chart below shows a flag pattern with general rules.

Bullish Flag Pattern (Example)

Strong Flag Patterns – Ideal Set up

The following rules describe an ‘ideal’ flag pattern to trade. For simplicity the description below is for a bullish flag. The opposite is true for a bearish flag.

Price makes a sharp rally with little to small retracements in between

Price starts to consolidate and makes minor lower highs and over a period a flag pattern forms with a slope

Using the equidistant tool in your charting platform, draw a channel for the flag

Measure the distance of the previous rally in pips

Using the Fibonacci tool, connect the previous rally top and bottom (connect using closing prices and not the highs and lows) and note the 38.2, 50 and 61.8 fib levels

The Set up

Price should retrace to 38.2% of the previous rally (although 50% and even 61.8% are also valid). In such cases, price usually breaks the lower end of the channel. This is even more validated when only the lows touch the 50% or 61.8% levels but not a concrete rule

Once price gets back into the channel, wait for a break out. Price must travel a reasonable yet small distance (and usually have a couple of candles opening and closing outside of the channel break out)

Note the price level of break out and add the distance calculated from the previous rally prior to this consolidation. This gives you the target

Set a pending buy order at the break out price with stops at the low prior to the break out with the calculated target

During the scope of the expected travel, price continues to make minor retracements. To further extend the profitability of the flag patterns, add to positions at the high prior to the retracements with stops set to to the first trade’s entry

The positions that you build with the flag pattern can be managed by trailing the stops of the original entry to key retracement levels. Stops should be trailed such that the first trade’s new stop level covers the risk of the added position. This way, even if price drops back and you get stopped out, the risk is evened out.

Flag Pattern (Bullish) – Trade Example

Flag Patterns – Other important points

In the context of the forex markets, the 4 hour time frame offers the best flag pattern set ups. Although flags are formed across different time frames, the 4 hour chart is ideal as it is reasonably balanced even during new releases. Always check the daily charts or weekly if need be to ascertain the prevailing trend and only trade flags that are within the larger trend. In other words, no matter how tempting a set up might look like, always stay with the trend. Line charts are ideal for plotting and identifying flags as the wicks from candlesticks can be distracting and thus hide the pattern some times.

Although flag patterns might come across as discretionary trading, when sticking to the above rules, a trade should be able to trade the flag patterns when they meet the criteria. Another advantage of the flag pattern from 4-hour charts is that because of the consolidation phase, traders can also set alerts at the three Fibonacci levels so they don’t have to spend time staring at the charts.

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